financial and banking regulation and supervision within the eu

Alongside inefficient capital and liquidity management, risks of financial innovation, of interconnectedness between banks and governments and of shadow banks also the regulation and sup

Financial and Banking Regulation

and Supervision within the Eu

constanze lehleiter

Dealis Fund Operations Governance, Risk and Compliance,

Herriotstr 1, Frankfurt am Main D-60528, Germany E-mail: constanze.lehleiter@dealis.de

abstract: The European Union (EU) has faced not only the international

financial crisis, but also the European banking and the sovereign debt crisis A lack of efficient regulations and supervision were a serious cause of recent developments As a reaction, the EU finally implemented a framework covering both micro- and macro-prudential policies Measures such as the new capital requirements, the deposit guarantee schemes, the green paper on shadow banking and, most importantly, the new approach for a macro-prudential supervision are headed towards crisis prevention However, the challenge is to define regulations enhancing financial stability, which, at the same time, do not prevent institutions from generating reasonable financial risks and do not reduce growth In that regard, the presented measures still have deficits which have to be faced Furthermore, coordination between various authorities and the European Commission remains another challenge

EU has had to react to the European crisis, which is composed of three different developments that even triggered each other

First of all, the international crisis, interpreted by Strauss-Kahn as the

‘great recession’ (Wearden, 2009) seriously hit European countries Recent developments with origins in the United States’ mortgage loan sector have affected international financial markets and, partly, have spread further to public finances and the real economy was also seriously affected Although the origins and causes of these developments are numerous (for a thorough summary

of the causes see Larosière et al., 2009) it can be concluded that the crisis is

the outcome of a markets’ and regulations’ failure and of an ineffective risk management (Mildner, 2012) It spread over to the European market because many European banks had invested in the US mortgage sector

Secondly, at the same time a European banking crisis was developing Also, loans have increased dynamically within the EU while interbank activities have enlarged The overheating of real estate markets in some Member States, also triggered by the reduction of interest rates, led to its collapse and to immense credit losses Serious consequences on the banking sector followed, especially within Ireland and Spain (Issing, 2012) Alongside inefficient capital and liquidity management, risks of financial innovation, of interconnectedness between banks and governments and of shadow banks also the regulation and supervisory systems failed within Europe Systemic relevance has been ignored Finally, the EU consisting of eurozone and non-eurozone countries had its structural deficits already before the outbreak of the international financial and European banking crisis The so-called sovereign debt crisis of some eurozone members had its origins not only in the international financial crisis but also in fundamental shortcomings of the eurozone In the case of Greece and Italy, for example, developments of debts were considerable already before 2007 (Issing, 2012) By lending money to governments, the fragility of banks was already affected by the sovereign debt crisis They lost a part of their credit receivables

In order to react immediately to this ‘systematic crisis’ (Sachverständigenrat, 2012b, p 5) especially high-debt countries such as Greece, Portugal, Spain and Ireland were supported by fiscal crisis-management measures and by both monetary policy and non-standard policy measures of the European Central Bank (ECB) In any case, existing regulation and supervision mechanisms could neither mitigate the effects of the crisis nor prevent its causes

The main objective of this paper is to give an overview about how the EU responded to recent developments and its causes in order to improve crisis prevention and whether it did it in an effective way Crisis prevention means reduction of the probability and severity of crises and systemic risks within the

EU and globally It may be achieved by enhancing financial stability However, measures aimed to improve financial stability may have negative side effects

on real economic processes such as competition and growth As banks are

an extremely important funding source for enterprises within Europe and the structural reform may have consequences for credit intermediation, the impact

of measures not only for financial markets but also for the whole economy will

be mentioned, too

The paper is focussed on the banking sector as banks have a pivotal role for the

EU and thus are especially vulnerable in times of crisis

2 Key issues of financial and banking integration within the EU

To be able to assess the crisis-prevention actions taken by the EU it is important first to consider the fundamental characteristics of the European financial market and especially its banking sector It is most important to see this market embedded in the continuous process of integration

2.1 The banking sector within the EU financial market

The EU financial market consists of 28 national markets with differences regarding its economical origins and to some extent regarding its currencies Within the banking sector, however, clusters can be built regarding shares of assets, loans, deposits and also employees The first cluster consists of banks residing in the EU-15 countries building the core of the intra-EU banking market The second cluster consists of banks residing in countries which became member of the EU with the eastward expansion in 2004 Although its power in the form of EU-wide assets, loans and deposits is much smaller compared to the first cluster, the figures increased instead of declining, contrary to many of the EU-15 banks (European Banking Federation, 2012)

Central and Eastern European (CEE) countries were not affected by the crisis

as much as the Western European countries There are considerable differences regarding their bank performance: In 2011, the return on equity of Estonia, Lithuania, Poland, the Czech Republic and Slovakia dominated the top of the ranking lists Furthermore, almost all banks of the CEE countries exceed the ratio of bank capital to assets compared to EU-15 countries (European Banking Federation, 2012)

2.2 Structural shortcomings before the crisis

Structural problems existing in the EU financial market in general and in its banking sector in particular contributed a lot to the poor developments The most important ones will be presented below First of all, the capital adequacy

of many systemic relevant banks was insufficient In Germany, for example, mainly banks with low capital adequacy were affected by the developments (Sachverständigenrat, 2012a) Secondly, banks and governments are interconnected with each other either through direct ownership participation of governments in banks or owing to the fact that banks buy government bonds This relationship can have negative consequences in times of crisis, as it was the case in many crisis countries such as Ireland and Spain Furthermore, until the outbreak of the crisis, partly due to the objective of integrating financial markets, European banks were highly interconnected Their financing was increasingly taken up through the interbank market and a short-term exchange of liquidity was possible Becoming at the same time more vulnerable to systemic risks, an effective restructuring in the crisis was difficult, also as international interdependence augmented (Sachverständigenrat, 2012a) Fourthly, a further structural problem evolving already before the outbreak of the financial crisis was the change of revenue and financing structure of banks Related to the balance sheet total, interest income has decreased, while income from more volatile transactions leading to a higher market risk increased Concerning the financing through the bond markets, the proportion of secured financing increased, especially among banks in the crisis countries (European Central Bank, 2012a)

Finally, also the European banking sector suffered from a clear lack of adequate macro-prudential supervision for financial markets There was no effective early warning mechanism that could have translated assessment of risk into action

(Larosière et al., 2009).

2.3 financial integration: advantages and shortcomings

Originally, financial integration within the EU has been seen as a catalyst for economic growth If market integration reached its optimal form, more opportunities for risk diversification, better allocation of capital and higher economic growth may be the result (Commission of the European Communities, 2007)

In its 2007 European Financial Integration Report, the Commission reports about

an almost complete integration in the unsecured interbank deposit market and

government bond market and a rising degree of integration of equity markets and corporate bonds Furthermore, before the outbreak of the crisis, EU financial markets became increasingly open for international activities Innovation in the form of new products, distribution channels and market practices increased However, already in this report the Commission admits that integration may also serve as a channel for cross-border contagion, transmitting risks across the financial system (Commission of the European Communities, 2007).

After the outbreak of the crisis the trend of financial market integration changed Markets are becoming increasingly fragmented, which is reflected in the interbank payment system TARGET2 (European Central Bank, 2012b) On the interbank market, the share of cross-border transaction has decreased, and domestic assets are used progressively as collaterals for refinancing operations with the ECB Furthermore, risk premiums for cross-border bank transactions have risen, while corporate interest rates partly clearly differ between the eurozone countries (Sachverständigenrat, 2012a)

While the EC still considers the completion of the single market in financial services as a crucial measure in order to stimulate economic recovery in Europe, the focus has changed Today, integration of financial markets also means to establish a crisis-prevention regulatory framework and a banking union (BU) with a Single Supervisory Mechanism (SSM)

3 the most important crisis-prevention policies

taken or considered by the EU

As shown by recent developments, micro-prudential regulation may become inefficient in sufficiently managing risks and discovering them timely Therefore, today, acute crisis management is accompanied by creating a new legislative framework of financial market rules and by changing the architecture

of the European financial markets The macro-prudential approach is taken into account (for detailed information about this approach see Hanson, Kashyap & Stein, 2011)

Until now, the Commission has not only proposed all the main legislations linked

to G-20 commitments, but has also adopted or proposed additional provisions aimed to stabilise the single market in financial services and to efficiently implement it Additionally, institutional changes of supervisory mechanisms have been undertaken and are still in the development process

3.1 Responding to insufficient capital adequacy

During the last three decades, the Basel Committee on Banking Supervision (BCBS) has developed essential provisions concerning the banking sector Its recommendations are the relevant international standard for banking regulation, especially on capital adequacy, the core principles for effective banking supervision and a concordat on cross-border banking supervision (BIS, 2013)

On the EU level these recommendations have been transposed into the Capital Requirement Directive (CRD)

a) EU legislation in force: The CRD actually consists of two directives: Directive

2006/48/EC, which is related to the taking up and pursuit of the business of credit institutions and Directive 2006/49/EC focussing on the capital adequacy

of investment firms and credit institutions (European Parliament and the Council, 2006a,b)

In order to ensure the consistent application of Basel II (which is based on three pillars: the minimum capital requirements, the supervisory review process and market discipline), these directives determine the prudential framework for investment firms and credit institutions According to Basel II, different approaches to capital adequacy, which allow institutions to use risk-measuring methods best suited to their risk profile, were established.Supervisory authorities assess the amount of risk capital that institutions must have at their disposal depending on the type of risk—either credit risk, market risk or operational risk The rules concerning credit risks are set out in Directive 2006/48/EC whereas Directive 2006/49/EC is concerned with market and operational risks faced by

investment firms and credit institutions

As a first reaction to the crisis, the Commission strengthened the regulatory framework in those areas which were relevant to the causes of the crisis In May

2009, the Council and the EP officially adopted Directive 2009/111/EC (European Parliament and the Council, 2009b),which is part of the so-called CRD II package In order to safeguard the financial safety of banks and investment firms Basel II was thereby more specified and a basis for implementation at national level was created (Schulte-Mattler & Dürselen, 2009) A further amendment followed with Directive 2010/76 (European Parliament and the Council, 2010a), which was adopted in November 2010 (CRD III package)

b) Upcoming legislation: CRD IV and CRR: Although the amendments of the

CRD were one step towards enhanced crisis-prevention and financial stability, Basel II has been criticised for its extreme complexity, its difficulty to be adapted

to irregular situations and its likelihood to lose control over the system as a

whole (Ohler, 2009) Thus, systemic risks were still not sufficiently covered by this measure.

Table 1 Rough overview of the capital requirement measure (CRD/CRR IV)

Regulation Dimension / Measures Goals Stability of a single bank

(micro-prudential) Banking system resilience (macro-prudential)

Strenghtening

capital base

of the banking

system

Quality and quantity of capital base:

Stricter eligibility rules, core equity, contingent capital, new narrowly defined Common Tier 1 Ratio (CET1), new/increased deductions;

unrealised gains and losses

Capital buffer to limit excessive credit growth:

Introduction of capital conservation and countercyclical capital buffers; higher capital requirements for systemic derivatives

Restricting

leverage Maximum leverage ratio (gross, non risk-based, on and off balance sheet

items at full conversion) Increasing

liquidity Short-term stressed ratio (Liquidity Coverage Ratio) Derivatives: Longer margin periods on positions (to reflect potential

liquidity) Strengthening

funding Long-term structural ratio (Net Stable Funding Ratio)

Derivatives (higher risk weights

if not cleared bu a central counterparty);

interconnectedness (higher risk weights to exposures to financial institutions due to high correlation of rating drop);

Enhancing risk

assessment and

measurement

Correcting risk-measurements methods (assessing market risk under stress scenarios)

Reducing pro-cyclicality: Use probability-of-default estimates from downturn periods, forward- looking expected-loss approach to provisioning.

Source: Composed by the author based on European Parliament, 2011

As a consequence, Basel III was published in December 2010 by BCBS In order to transpose it into EU law, in July 2011 the EC adopted a legislative package with the main objective to make the financial system more resilient

to future crises The proposal of the renewed capital requirement provisions comprises two legal acts, a directive and a regulation, which shall replace the current Directives 2006/48 and 2006/49 Not all transposed measures correspond exactly with the Basel III rules Some are proposed in addition

Main parts of the Basel III framework are implemented by the regulation, which

is directly applicable (European Parliament and the Council, 2011a) It provides for detailed prudential requirements for credit institutions and investment firms and regulates relevant subjects like own funds, liquidity, leverage ratio and counterparty risk This so-called ‘Single Rule Book’ is an important renewal, as national discretions shall be mainly abolished

Complementarily, the directive governs, amongst others, the principles of prudential supervision (European Parliament and the Council, 2011b) The subjects of the Directive are fundamentally based on Basel III, nevertheless,

it includes further details and extensions of requirements into the proposal New issues are requirements regarding corporate governance, sanctions, capital buffers and supervisory processes Being adopted by the EP in April 2013 both the CRR and CRD IV are expected to come into force by January 2014 In accordance with certain transitional regimes, the requirements of the CRR shall become fully operational by January 2019 Based on Basel III the new EU provisions will explicitly face micro- and macro-prudential objectives

3.2 responding to further challenges

The Commission created numerous further provisions concerning not only the banking sector but also other sectors of financial markets Two of them will be addressed in this context

a) Missing liquidity and lack of confidence: Also derived from a G-20 commitment,

the Deposit Guarantee Scheme Directive (DGSD, European Parliament and the Council, 2009a) shall strengthen consumer confidence and investor protection

It protects the bank deposits of depositors in the event of bank insolvency and may contribute to financial stability by preventing depositors from making panic withdrawals from their banks (European Commission, 2013b) Aiming to further harmonise the DGS, the Commission proposed in July 2010 an amending provision In its proposal, it restricts the maximum repayable amount to 100,000 euros for each depositor and DGS will be obliged to mutually grant loans to other schemes that cannot fulfil its obligation (European Parliament and the Council, 2010b) The proposal is of special importance because it is foreseen to

be a main element of the envisaged BU

b) Shadow bank systems: Shadow banks have played an important role triggering

the crisis, but within the EU they had not been in the focus of regulation and supervision until now Risks are especially seen in its systemic-relevant nature, its cross-jurisdictional reach and its interconnectedness to the regular banking

system This is especially risky as they can be used to avoid regulation or supervision (European Commission, 2012b).

In March 2012, the Commission presented its Green Paper Shadow Banking, which essentially analyses four issues: the definition of shadow banks and their activities, the advantages and drawbacks of shadow banks, the already existing regulation

on those and how future regulation should be As defined by the Commission, shadow banks are, for example, investment funds, finance companies or insurance and reinsurance undertakings, which provide alternative credits for investors without being subject to regulations of the banking sector, such as to the CRD It

is estimated that shadow banks manage approximately one quarter of the whole volume of the financial sector (European Commission, 2012b)

3.3 Responding to inefficient supervisory mechanisms

The original European supervisory framework consisted of three financial committees for micro-financial supervision but did not include a body responsible for supervision of systemic risks As a consequence, for the first time a framework for both micro- and macro-prudential supervision was defined under special consideration of the ‘Larosière report’ (Europa Press Release, 2009)

a) Legislation in force: The European System of Financial Supervisors (ESFS):

Between 2009 and 2011 numerous reforms of the supervision system took place

As a first step, a European Systemic Risk Board (ESRB) was established and three new European authorities for the supervision of financial activities were set up: the European Banking Authority (EBA), the European Securities and Markets Authorities (ESMA) and the European Insurance and Occupational Pensions Authorities (EIOPA) These authorities shall work in tandem within the newly established ESFS, which also consists of a network of national financial supervisors The three European Supervisory Authorities (ESAs) shall closely cooperate with the ESRB (European Parliament and the Council, 2010c) The new system came into force in January 2011

The role of the ESRB is to monitor and assess macro-prudential aspects whereas cooperating national authorities and the three newly created authorities carry out micro-prudential supervision

b) A new proposal: The Single Supervisory Mechanism (SSM): Although

systemic supervision today is exercised by the ESRB, there are still lacks concerning its competences to directly intervene Furthermore, the surveillance

of macro-prudential regulations is still given to national authorities

The Commission suggested a set of legislative proposals on the establishment of a SSM for banks led by the ECB It has to be seen as a first step towards a BU, which shall also consist of a single rulebook, common deposit protection and a single bank resolution mechanism The proposal includes a regulation conferring strong powers on the ECB related to supervisory tasks and another allying the existing regulation on the EBA to the proposed set-up and a communication outlining the overall vision of the EC for the envisaged BU (Europa Press Release, 2012) The European Parliament, the European Council and the Commission recently agreed

on that proposal; formally it is not yet adopted

The new mechanism will apply to all eurozone Member States while it is open

to the participation of the other EU countries It confers elementary supervisory tasks and powers to the ECB The ECB will be responsible for the supervision

of all 6,000 banks of the eurozone; however, it directly supervises the highly

‘significant’ banks (which have either assets of more than 30 billion euros, constituting at least 20 per cent of their home country’s GDP or have requested

or received direct public financial assistance from the European Financial Stability Facility or European Stability Mechanism) At the same time, national supervisors will still directly supervise the other banks in their member states The ECB monitors this process and is able to decide to directly supervise also these banks (European Parliament and the Council, 2012, Art 4, 5) The Commission considers the new role of the ECB therefore as the key to delink sovereign and banking risks (European Commission, 2013a)

4 Evaluation of the success or failure of the most important

measures

At this point it should be mentioned that external influences or shocks will never

be fully prevented As financial risks represent the core of the businesses of financial institutions they will have to deal again with it (Draghi, 2008) Thus, the central question is in how far the EU responses will enhance crisis prevention

by either achieving a stable financial banking system or by discovering an upcoming risk timely It is further important to analyse potential side effects and impacts on other economic processes